Rethinking the Development of the Automobile Industry in China

Transcription

1 University of Denver Digital DU Electronic Theses and Dissertations Graduate Studies Rethinking the Development of the Automobile Industry in China CHEN GU University of Denver, guchenbfsu@gmail.com Follow this and additional works at: Recommended Citation GU, CHEN, "Rethinking the Development of the Automobile Industry in China" (2014). Electronic Theses and Dissertations This Thesis is brought to you for free and open access by the Graduate Studies at Digital DU. It has been accepted for inclusion in Electronic Theses and Dissertations by an authorized administrator of Digital DU. For more information, please contact jennifer.cox@du.edu.

2 Rethinking the Development of the Automobile Industry in China A Thesis Presented to the Faculty of Arts and Humanities University of Denver In Partial Fulfillment of the Requirements for the Degree Master of Arts by Chen Gu November 2014 Advisor: Peter Ho

3 Author: Chen Gu Title: Rethinking the Development of the Automobile Industry in China Advisor: Peter Ho Degree Date: November 2014 ABSTRACT Governmental industrial policies have significant influence on industrial performance. Many developing countries that lack capital and a good technology base use foreign direct investment (FDI)-dependent governmental policies to induce multinational corporations (MNCs) to invest in their indigenous immature industries. In this article, the Chinese automotive industry, which is regulated directly under the Chinese central government, is used to illustrate the interactions between the complex FDI-dependent governmental policies and the industrial development of developing countries. According to changes in Chinese automotive industry policy, the Chinese auto industry s development process is divided into four phases: extremely passive FDIdependent policy phase, partial strategic FDI-dependent policy phase, ISI restructuring phase, and industrial upgrading phase. Considering those four phases, the overall industrial characteristics and policies of China s automotive industry are introduced and analyzed. Then, a systematic analysis is carried out to explore the key reasons for the policy failure and distortion. The results indicate the successful application of FDIdependent industrial policies is subject to numerous conditions, such as the content of policies, policy implementation, and the economic environment of a country. In the end, a few policy recommendations, including reforming the ownership structure of stateowned enterprises, promoting mergers and acquisitions between inefficient firms in order to attract high-quality investment from MNCs, etc., are proposed. ii

4 TABLE OF CONTENTS Chapter One: Introduction... 1 Chapter Two: Literature Review... 5 Empirical Literature Reviews on the Effects of MNCs and FDI... 5 MNCs and Foreign Trade... 6 MNCs and Domestic Firms Productivity... 7 MNCs and Market Structure... 8 FDI and Economic Growth... 8 Eclectic Paradigm Theory of FDI Utilization Theory Utilization in Case Study Chapter Three: First Phase ( ) Introduction of Extremely Passive FDI-Dependent Automobile Industrial Strategies ( ) Supply-Side Policy Demand-Side Policy The Effects of Passive FDI-Dependent Automobile Industrial Policy ( ) Chapter Four: Second Phase ( ) Introduction of Partial Strategic FDI-dependent Automobile Industrial Policy ( ) Supply-Side Policy Demand-Side Policy Market Creation The Impacts of Partial Strategic FDI-Dependent Automobile Industrial Policy ( ) Vehicles Components Chapter Five: Third Phase ( ) Regulation Liberation and Impacts ( ) The Impact of the Reduction of Tariffs The Impact of the Change of Car Import Quota The Impact of Opening the Chinese Car Industry to Foreign Investment New Automotive Policy and Effects ( ) New Automotive Policy The Effects of New Automotive Policy Chapter Six: Fourth Phase (2008 Present) Impacts of the Global Financial Crisis on China s Automotive Industry ( ) iii

5 Policy Revision and its Effects (2009 Present) Export Policy and Goals Auto Industry Upgrade Policy and Effects Chapter Seven: Conclusions and Policy Recommendations Conclusions Policy Recommendations Bibliography Appendices Appendix A: Chinese Automotive Industry Policy Appendix B: Chinese Automotive Industry Policy iv

6 LIST OF TABLES Table 1: Chinese Automobile Production, Table 2: Ownership of Chinese Indigenous Automotive Industry Corporations in Table 3: Saloon Vehicle Production in China, Table 4: Main Medium-Duty Truck Producers in China, 1998 (000) Table 5: Size Distributions of Chinese Component Makers, Table 6: FDI in Chinese Automobile Component Sector ( ) Table 7: Tariffs, Pre- and Post-WTO Membership Table 8: Capacity Utilization Rate of the Chinese Automotive Industry Table 9: Chinese Automotive Export Data in Table 10: Growth Rates of Exports in Chinese Automotive Industry ( ) Table 11: Ratio of Number of Vehicles Exported to Total Vehicle Production in China ( ) Table 12: Ratio of Export Values of Auto Products in China to Export Values of Auto Products Worldwide ( ) Table 13: Ratio of Number of Vehicles Imported to Number of Vehicle Sales in China ( ) Table 14: The Process of SAAB Acquisition v

7 LIST OF FIGURES Figure 1: The pattern of the investment development path Figure 2: Outward and inward FDI in the Chinese automobile industry ( ) Figure 3: Partnership structure between local and international auto firms in China Figure 4: World distributions of Chinese automotive exports in Figure 5: Exchange rates, RMB to euro/dollar ( ) Figure 6: Distribution of Chinese vehicle exports in 2013, by country of destination vi

8 ACRONYMS AND ABBREVIATIONS BAIC BMW BYD CAAM CATARC CKD FAW FDI GAIG GM IJV LLC ISI MNC NAC NDRC NOI SPC OICA PATAC PSA R&D Beijing Automotive Industry Holding Company Bayerische Motoren Werke AG Build Your Dreams China Association of Automobile Manufactures China Automotive Technology and Research Center Completely Knocked Down First Automobile Works (China) Foreign Direct Investment Guangzhou Automotive Industry Group General Motors Company International Joint Venture Limited Liability Company Import-substituting Industry Multinational Corporation Nanjing Automobile (Group) Corporation National Development and Reform Commission Net Outward Investment State Planning Committee of China International Organization of Motor Vehicle Manufacturers Pan-Asia Technical Automotive Center PSA Peugeot Citroën Research and Development vii

9 SAIC SOE SUV VW WTO Shanghai Automotive Industry Corporation State-Owned Enterprise Sport Utility Vehicle Volkswagen World Trade Organization viii

10 CHAPTER ONE: INTRODUCTION Throughout the global economy, governments play a significant role in protecting their local economies and promoting industrial development. Multinational corporations (MNCs) and foreign direct investment (FDI) industrial policies are the main instruments governments use to intervene in industrial evolution. Those governmental policies include: trade policies (e.g., tariffs, quotas, and other antidumping measures) that aim to protect the weak local market from foreign competition; support polices (e.g., tax incentives, subsidies, preferential loans, licenses, and government contracts) designed to promote the development of domestic companies; and foreign investment policies (e.g., joint venture regulations and local content rules) that seek to enhance production capacity, increase employment, and transfer technology know-how to foster linkages between indigenous markets and the global marketplace. The forms of industrial policies vary across countries, but they mainly focus on two purposes: protection and development. MNC- and FDI-related industrial policies have been successfully used around the world, such as in Japan and Korea, which employed infant-industry protection in their automotive industries. Although the advocates of the free-trade principle criticized these policies, Japan and Korea were able to obtain fast economic growth and increased development capability in the 1950s. However, this type of success did not happen in every country. Many less developed countries in Latin America and Africa failed to 1

11 achieve their industrial goals using industrial policy patterns similar to those used in East Asian countries. The Chinese automotive industry has been protected and regulated by the Chinese government through a comprehensive set of industrial policies for over 30 years. In this thesis, by examining the case of China s automotive industry since the 1980s, we try to demonstrate the internal relationships between government policy and industrial development as well as the interactions between government and industry. In line with changes in Chinese automotive industry policy as well as the characteristics of two related industrial development theories, the Chinese auto industry s development process has been divided into four phases. During the first phase, extremely passive FDIdependent policy ( ), China s economic opening and reforms stimulated a rapid growth of demand for vehicles while the production system that had been built largely for defense purposes was unable to satisfy the new demand. China had insufficient location advantages, so the government s role should be mainly providing basic infrastructure and the upgrade of the economy s human capital to attract MNCs and FDI. The second phase is partial strategic FDI-dependent policy ( ). This phase is a natural development of the first one. There was a veritable flood of investment into the Chinese auto industry during this stage. It resulted in a rapid increase of cars in total vehicle production. The FDI was mainly in the primary commodities and natural resources sectors amid a lack of created assets 1 endowment. The third phase is kind of 1 They differ from natural assets because, while these refer to physical assets of a country, such as natural resources, climate. or geographical situation, created assets imply a previous use of resources for an improvement of the development degree of a country. They are intangible, gathering technological or human capital resources. 2

12 import-substituting industry (ISI) restructuring policy ( ). China entered the World Trade Organization (WTO) in 2001, and nearly all the major international carmakers entered the Chinese automotive market. Tariffs, quota, and importation limitations should be cancelled under WTO rules, but the Chinese didn t want to practice free trade and still tried to protect inefficient SOEs and local carmakers with some industrial policies that were against WTO rules. On the other hand, with the trade benefit brought by WTO rules, car exports started growing in China. The main agents were domestic firms, and in other undeveloped or developing countries, they were MNCs. The last is the industrial upgrading policy (2008 present) phase, during which the WTO forced the Chinese central government to put auto industrial policies in line with its rules. Hence, China started to think about upgrading its industrial policies. The key factors that determine the success or failure of the Chinese auto industry are the research focuses. The success of industrial policies highly depends not only on the content of policies, but also on the policy implementation and the economic and political environment in a specific country. Therefore, three aspects should be considered in this study: the Chinese government, the automotive industry, and the volatile global economic environment. An economic system that is totally controlled by the Chinese government gives the Chinese government greater power to intervene in industrial development processes of the Chinese automotive industry. From 1978 to 2001, research mainly focused on government policy and its effect on industrial development. In 2001, China joined the WTO, and an increasing number of MNCs invested in the auto industry. All those changes created a different economic environment for the Chinese automotive industry. During this period, besides the FDI-oriented government policy, the economic 3

13 and political environment in China is considered a key factor in industrial evolution. Thus, in order to explore those key factors and gain a deep insight into the case study, the questions listed below will be answered in the research. We start by exploring the Chinese automotive industry policy strategy and trying to figure out which part of the policy was successful and which part has failed in the real world. Then we explore the main reasons for the inefficiency of China s automobile industry policies. Does the failure imply the deficit of the theory of FDI? What are the key factors that determine the success and failures? All those answers will provide information about the evolution and development of the auto industry in China, further shed some light on the possible role of the state in promoting the development of a particular industry, and illustrate how the process of industrialization may take place with aid from the state. 4

14 CHAPTER TWO: LITERATURE REVIEW This chapter consists of two parts. The first part introduces the general effect of MNCs and foreign direct investment (FDI), which include multinationals and foreign trade, multinationals and domestic firms productivity, multinationals and market structure, as well as FDI and economic growth. This part can help us have a general idea about the current research on MNCs and FDI. The second part is the introduction of Dunning s eclectic paradigm, which includes five development phases, depending on the level of GDP and net outward investment (NOI). The third part is the introduction of Sanjaya Lall s theory of FDI utilization, which includes four types of government policy interventions on MNCs: passive FDI-dependent policy, strategic FDI-dependent policy, ISI restructuring policy, and autonomous policy. Dunning and Lall both illustrate a dynamic framework in their theories. We will apply their theories to the case study and try to help the Chinese auto industry achieve progress step-by-step. Empirical Literature Reviews on the Effects of MNCs and FDI In order to find proper theories to help us analyze our case study (the Chinese automobile industry), a concise but comprehensive review and evaluation of the existing empirical literature will be discussed in this part. Generally speaking, literature that relates to MNCs and FDI is fragmented. Therefore, we summarize those empirical literatures in four categories: MNCs and foreign trade, MNCs and domestic firms productivity, MNCs and market structure, as well as FDI and economic growth. 5

15 MNCs and Foreign Trade It is difficult to find out whether MNCs tend to generate trade surpluses or trade deficits in the host economy. On the one hand, FDI inflows may reduce or increase imports received by the host country. There is evidence for both cases (Blomstrom and Kokko, 1997; Goldberg and Klein, 1999; Blonigen, 2001 and Swenson, 2003). Lipsey and Weiss (1981; 1984) find a positive relationship between FDI and imports but fail to think about endogeneity stemming from the characteristics of the host market. Bajo- Rubio and Montero-Munoz (2001), having corrected for endogeneity, also find a positive relationship, but Gruber and Mutti (1991), using similar data to Lipsey and Weiss (1981), find an insignificant negative relationship between FDI and imports. On the other hand, more evidence exists regarding the idea that FDI inflows increase exports of the host economy (Blomstrom and Kokko, 1997; Lipsey, 2002; Greenaway and Kneller, 2007). The relationship between FDI and trade is related to the predominance of vertical or horizontal MNCs. Markusen (2002) states that the weight of empirical evidence suggests the dominance of horizontal motives for foreign production. He defends this idea for the world, because most FDI flows are among developed economies, which, according to his view, tend to be horizontal. However, Markusen also acknowledges that vertically integrated firms are important in some industries and surely important in some host countries. Hanson (2003) has obtained robust evidence for the importance of vertical MNCs and gives a reason they find strong evidence of vertical FDI. This is because they use microlevel data on foreign affiliates, whereas previous work uses data that aggregate not just across the activities of a given affiliate but also across all affiliates. 6

16 MNCs and Domestic Firms Productivity One of the most studied effects of FDI is that of spillovers. Many studies of spillovers have focused on whether this transference of new technologies from MNCs affects domestic firms productivity. In this respect, the results are fairly ambiguous. On the one hand, some computable general equilibrium models report that FDI inflows raise welfare by increasing the number of varieties available for consumers (Bchir et al., 2001 and Rutherford and Tarr, 2008). And there are advanced techniques and know-how that MNCs bring to host countries. This may be transferred to domestic firms voluntarily through the creation of linkages or licensing agreements with domestic firms, or involuntarily through imitation or labor mobility. Haskel (2002) obtains evidence of positive horizontal spillovers in the United Kingdom. But these positive spillovers do not seem to be large enough to justify the amount of money spent by the government to attract MNCs. Smarzynska (2004) finds positive spillovers through backward linkages and no evidence for horizontal spillover in Lithuania. This indicates that vertical spillovers may be more likely than horizontal ones. On the other hand, Djankov and Hoekman (2000) find a negative effect of the presence of MNCs on domestic firms in the Czech Republic. Aitken and Harrison (1999) find evidence for negative spillovers on domestic firms productivity in Venezuela. FDI reduces the output of those firms, which makes them produce in less efficient points of their declining average cost curve, thus reducing their productivity. Grog and Greenaway (2004), Barba Navaretti and Venables (2004), and Crespo and Fontoura (2007) state a vague, and even negative evidence of MNCs effects on domestic firms productivity. 7

17 MNCs and Market Structure Theoretical predictions about the effect of FDI on market structure are consistent with both a pro-competitive effect and a more concentrated structure (Ferrett, 2004). Procompetitive effect indicates that MNCs promote competition and reduce the price-cost markup, while a more concentrated structure indicates the MNCs crowd out (less efficient) domestic firms with the danger of turning the market into a more oligopolistic structure. Markusen and Venable (1998, 2000) show that the type of firm (MNCs versus domestic) that prevails will depend on the relative endowments and size of countries, the level of transport costs, and firm-level and plant-level economies of scale. Therefore, in the end, whether MNCs crowd out domestic firms is an empirical matter (Barba Navaretti and Venables, 2004). FDI and Economic Growth MNCs often possess higher skills and experience, exhibit more advanced techniques, have high levels of R&D expenditures, etc. These characteristics lead to thinking about the role of MNCs as promoters of technological innovation and progress and, therefore, economic growth. There are many empirical case studies to support that idea. Obadan (1992) discovered a positive, statistically significant relationship between economic growth and the FDI inflow. In his study of the Nigerian economy for the period , it was observed that the economy grows at an average rate of 1.85% per annum. Campos and Kinoshita (2002) examined the effects of FDI on growth for the period for the 25 Central and Eastern Europe and former Soviet Union transition economies. In these countries, FDI was a pure technology transfer. The main 8

18 results indicate that FDI had a significant positive effect on economic growth of each selected country. However, given the intangible nature of these assets it may be difficult to empirically grasp their effect on growth. The results of empirical studies indicate that FDI increases growth when host economy characteristics point to the existence of an absorptive capacity. What exactly constitutes that absorptive capacity varies. It may be related to high-income-level countries (Blomstrom, Lipsey and Zejan, 1994), an open trade regime (Balasubraanyam, 1996), a highly educated workforce (Borensztein, 1998, Campos and Kinoshita, 2002) or well-developed financial markets (Alfaro, 2004; 2006). An exception to this positive relationship is the study by Carkovic and Levine (2005). Using a panel for 72 economies over the period they find no evidence that FDI flows have an impact on GDP growth. However, using the same methodology in an analysis for a group of developed and homogeneous economies, Bajo-Rubio (2008) found a clear positive impact of FDI on growth. The study of MNCs and FDI has been a fertile research topic, and a number of authors have devoted their efforts to review the literature. We find that this is a very fragmented area of the literature, in which there are dispersed contributions and different strands according to the particular effect of MNCs analyzed. In this circumstance, the effects of MNCs have been very much debated, and there is still some controversy regarding their impact on host economies. Therefore, it seems difficult to obtain an economy-wide evaluation of their impact. Also, empirical literature reviews are aimed to evaluate the effects of MNCs and FDI on host countries, while few studies analyze how countries use policies to influence 9

19 MNCs investment activities and then achieve industrial development. In spite of that, few empirical studies are related to the effect of MNCs and FDI on those developing countries in Asia, which have different cultures and economic environments from European countries. Even though empirical literature analyzing how developing countries in Asia use policies to influence MNCs investment activities is rather scarce, we find them. Dunning s (1997, 1979, 2000) eclectic paradigm and Sanjaya Lall s theory of FDI utilization are a good fit for our case study. Eclectic Paradigm In eclectic paradigm theory, Dunning provides a triad of conditions necessary for a firm to become a MNC. He points out ownership advantage, location advantage, and internalization advantage as three key determinants that a firm should look into upon entering the market. Ownership advantage suggests that a firm must possess specific advantages that make it strong enough to compete with local firms. This can also be regarded as competitive or monopolistic advantage. Location advantage is the idea that for a MNC to establish a new plant in a foreign country, this country must have some advantages compared to the home country of the MNC. These advantages may be cheaper factors of production, better access to natural resources, a bigger market, etc. Finally, internalization is the degree of control over foreign affiliate that is higher through FDI than licensing a local firm. So it suggests a firm exploit its ownership advantages within its subsidiaries rather than sell or license them to other local firms. The central concepts of the eclectic or OLI paradigm have also been introduced in a dynamic framework known as the investment development path (IDP). IDP relates the inward and outward direct investment position of countries with their corresponding 10

20 stages of development (Dunning, 1981; Dunning and Narula, 1996). According to this theoretical framework, countries tend to go through five development phases. Each of the stages links the GDP level and the country s net outward investment (NOI) position, defined as the difference between outward direct investment stock and inward direct investment stock. Figure 1. The pattern of the investment development path. Source: Dunning and Narula (1996). According to the pattern of the IDP in Figure 1, the first phase of the IDP refers to the least-developed countries that face a negative NOI position; because they are net FDI receivers, they mostly take advantage of the country s natural resources. On the other hand, outward FDI is negligible or nonexistent. The second phase is a natural development of the first one. The NOI position decreases because of an increase inflow of FDI, even faster than the GDP growth, while outward investment remains low or negligible. The third phase includes the so-called emerging countries. They exhibit a 11

21 growing NOI position due to an increased rate of growth of outward FDI and a gradual slowdown of inward FDI. Phase four is distinguished by a shift to a positive NOI position, as outward FDI stock exceeds inward FDI stock. Finally, in the fifth phase, we find the most advanced countries, such as United States, Japan, or the United Kingdom, in which NOI position tends to fluctuate around zero while reflecting high levels of inward and outward FDI. According to Dunning and Narula (1996), the investment development path can be framed as follows. During the first stage, countries have insufficient location advantages, thus both inward and outward investments are extremely limited and the MNCs prefer to access these countries through trade as well as through entering into nonequity relationships with local firms. Under this situation, the government s role should be mainly providing basic infrastructure and upgrading the economy s human capital, through educational and training programs, as well as implementing importsubstitution and export-promotion policies that affect the structure of local markets and industries. During the second phase, as a country develops, the improvement of its locational advantages leads to a growth of inward FDI, especially in primary commodities and natural resources, as well as in industries that are intensive in physical capital and low-qualified work, i.e. sectors whose endowment of created assets are scarce. At this time, government policies may influence the process through incentives or tariffs, as the competitiveness of local firms at this stage is still very low and the outward FDI remains extremely low but larger than in the first stage. The third/intermediate phase shows an increase in the economy s income per capita, an acceleration of industrialization, and a greater specialization of demand oriented towards superior-quality 12

22 products. Competition in the domestic market rises as the ownership advantages of the inward investors diffuse through the local industry. As a result, the domestic firms start developing their own advantages. The ownership advantages of local firms become increasingly associated with the property of intangible assets so they less dependent on government polices but the role of the government is still relevant and oriented towards a reduction of market failures and inefficient industries, as well as towards promoting an increasing integration of local and foreign companies, which minimizes the delocalization risks. The incentives policy should aim to attract FDI through activities in which local companies do not have competitive advantages as well as to stimulate domestic firms to exploit their own advantages in new markets. At the fourth stage, the country s location advantages begin changing from cheap labor force and natural resources to created assets sophisticated markets, qualified labor, technological capacity of the more dynamic sectors, and development of economies of agglomeration. The production processes are more capital-intensive, reflecting a lower cost of capital compared with the cost of labor. Concerning the role of the government, it has to ensure competition among national and foreign companies and suppress the existing market failures. In the fifth phase, the NOI stock becomes irrelevant as a result of the growing similarity between the most advanced countries. This means that the NOI will vary between a positive and a negative position, depending on the evolution of exchange rates and economic cycles, as well as on the firms individual strategies. As a result, FDI depends less on the condition of the host countries and more on the localization strategies of MNCs. Regarding the government, the role of government takes on a strategic dimension, increasingly behaving as an oligopoly with MNCs and other governments. 13

23 In synthesis, we can say that location advantages, including appropriate government policies and basic infrastructure, are particularly relevant in the first three stages of the IDP. The existence of a favorable institutional framework which helps the development of ownership advantages in local firms, the increasing international mobility of operations, and the accumulation of technological and knowledge-intensive assets seems to constitute the acceleration factor of direct investment abroad and of the progression towards the fourth and fifth phases of development. Regarding the empirical part, Dunning, Kim, and Lin (2001) had Korea and Taiwan as a case study where the IDP concept was extended. According to them, the growth of trade and FDI is positively correlated with gross national product per capita and with the created asset intensity of products. Theory of FDI Utilization Sanjaya Lall (2003) argued the theory of FDI utilization in his book, Competitiveness, FDI and Technological Activity in East Asia, after exploring a panel of nine developing countries (China, Korea, Taiwan, Singapore, Malaysia, Thailand, Philippines, Indonesia, and Hong Kong) in East Asia over the period The theory advocates that MNCs have advantages over immature domestic firms in management, production, engineering, design, distribution, marketing, etc. So inducing MNCs to invest in immature domestic industries in the developing countries can be a highly effective means of transferring technologies and building production capabilities in immature domestic firms. According to Lall s argument, while MNCs can be a highly effective means of transferring technologies and building production capabilities, they may be less effective 14

24 in deepening and broadening them 2. For example, MNCs initially transfer equipment and technologies suited to existing skills and capabilities. At this stage, they do invest in upgrading local skills, technological capabilities, and supply chains, but only to the extent that it is profitable in commercial terms (to implement production technologies). MNCs will go beyond this, but only if the skill base is growing, local suppliers are improving their capabilities, technology institutions can provide more advanced services, etc. 3 Moreover, the immature domestic firms in the developing countries have little chance to survive the competition of the MNCs, which offer high efficiency, high quality, and low price for similar products and services. All of these need active government policies. Thus, the key parts of the theory are to illustrate why and how to use government policies to induce and intervene in MNCs investment activities in order to foster the development of an immature industry. Overall, Lall points out that government policy interventions in MNCs are mainly four types (Lall, 2003). Passive FDI-dependent industrial policy is driven by FDI but relies largely on market forces to upgrade the structure. The main tools are a welcoming FDI regime, strong incentives for exports, good export infrastructure, and cheap, trainable labor. Skill upgrading and domestic technological activity are relatively neglected (although some countries have a relatively good base), and the domestic industrial sector tends to develop in isolation from the export sector. 4 2 Sanjaya Lall, Competitiveness, FDI and Technological Activity in East Asia, p. 34, April Sanjaya Lall, Competitiveness, FDI and Technological Activity in East Asia, p. 35, April Sanjaya Lall, Competitiveness, FDI and Technological Activity in East Asia, p. 36, April

25 Passive strategies involve less industrial policy in export-oriented activities to start with (although there may be intervening in domestic-oriented activity). They need to evolve into more targeted strategies if countries are not to lose their competitive positions and momentum. 1. Strategic FDI-dependent industrial policy is driven by FDI and exports within integrated production networks. There is a strong effort to upgrade MNC activity according to strategic priorities, directing investments into higher-value-added activities and inducing existing affiliates to upgrade their technology and functions. This strategy involves extensive interventions in factor markets (skill creation, institution building, infrastructure development, and supplier support), encouraging R&D and technology institutions and attracting, targeting, and guiding investments. 5 Strategic FDI-dependent strategies entail considerable industrial policy, but the intensity of government intervention is lower than with autonomous strategies that will be introduced below. The sources of technical change remain largely outside, in the hands of MNCs; there is less need to intervene to promote learning in infant industries for this reason. However, industrial policy is needed to ensure the development of the relevant skills, capabilities, and institutions required to ensure that MNCs keep transferring new technologies and higher-value functions. 6 5 Sanjaya Lall, Competitiveness, FDI and Technological Activity in East Asia, p. 37, April Ibid. 16

26 2. ISI restructuring involves exports growing from established importsubstituting industries where competitive (or nearly competitive) capabilities have developed. The main policy tool is trade liberalization or strong export incentives (some, as in Latin America, within regional trade agreements). This leads to considerable upgrading, restructuring, and expansion of these industries along with their supplier networks. In some countries, the main agents are domestic enterprises, and in others, they are MNCs. The main difference from the autonomous strategy is the lack of clear and coordinated industrial policy to develop export competitiveness, with haphazard (and often weak) support for skills, technology, institutions, and infrastructure Autonomous is based on the development of capabilities of domestic firms, starting with simple activities and deepening over time. This strategy uses extensive industrial policy, reaching in to trade, finance, education, training, technology, and industry structure. It involves selective restrictions on FDI and actively encourages technology imports in other forms. All these interventions are carried out in a strongly exportoriented setting, with favors granted in return for good export performance. 8 Regarding the last type of strategy, Lall also points out that from the policy aspect, autonomous strategies entail a great deal of industrial policy and accompanying 7 Ibid. 8 Sanjaya Lall, Competitiveness, FDI and Technological Activity in East Asia, p. 47, April,

27 interventions in factor markets and institutions. Interventions, generally in the form of tariff, quota, etc., may result in an oligopoly and a higher domestic price in the protected domestic market than that in the international market. Then the high price may cover the higher production costs and help the inefficient immature firms remain in business. With the profits gained inefficiently during the protection period, the domestic firms would improve their experience and efficiency such that they improve quality and reduce operational costs. In the end, government interventions lead to massive development and deepening of indigenous skills and technological capabilities, with a national ability to keep abreast of new technologies and for domestic enterprises to become significant global players in their own right. However, such strategies are increasingly difficult and risky on economic grounds the sheer pace of technical change and the growth of international production systems raises the costs of being left on the outside. They are also increasingly constricted by the new rules of the game being laid down by international agencies and developed countries. Consequently, Lall (2003) also demonstrates that the utilization of those four types of strategies is not static. Those using passive FDI strategies are moving towards more targeted strategies. Strategic FDI-dependent countries are trying to strengthen capabilities in domestic firms and build up the institutional structure for innovation. Autonomous countries are becoming more integrated into MNC systems (and have many capable MNCs of their own). These changes are driven both by new technologies and globalization as well as by new rules of the game and are likely to persist into the foreseeable future. 9 This does not mean that countries will converge technologically. 9 Sanjaya Lall, Competitiveness, FDI and Technological Activity in East Asia, p. 57, April,

28 There will remain significant differences in technology and competitive performance because of differences in endowments (size, location, resources, etc.) and in inherited structures of technological learning. National systems of technology development have elements of path dependence and stability and can change only as the institutional, technological, and human capital base evolves, so it is necessarily a slow process. 10 Inherited structures also influence how flexibly and dynamically countries respond to new competitive challenges. This feedback process can let leaders maintain their advantage for very long periods. FDI can help to change national technological systems, but the real driver of change lies within each economy. Government policies and institutional structures together play a vital role here, and this role remains even as its form and content evolves. On the other hand, according to Lall (2003), governments should use policy intervention on MNCs as well as support local firms growth. With a completely passive policy, MNC exports can remain at low, technologically stagnant levels. Thus, an MNCdependent export strategy needs a proactive element of dynamic competitiveness. More importantly, depending on FDI is not a substitute for strengthening domestic capabilities. 11 There are many activities that MNCs should not enter, including many localized ones that tend to be populated by SMEs (small and medium enterprises). They also need efficient local suppliers if they are going beyond the assembly of imported components. Capturing the spillover benefits of foreign presence needs capable local firms. More importantly, a strong base of national enterprises can lead to broader, deeper, 10 Sanjaya Lall, Competitiveness, FDI and Technological Activity in East Asia, p.59, April, Sanjaya Lall, Competitiveness, FDI and Technological Activity in East Asia, p. 63, April,

29 and more flexible capabilities because the technology development process with foreign affiliates may be curtailed as compared with local firms. The very fact that an affiliate can draw upon its parent company for technical information, skills, technological advances, etc. means that it needs to invest less in its own capabilities. This applies particularly to functions like advanced engineering, design, or R&D, which MNCs tend to centralize in industrial countries. As industries mature, it is imperative for developing countries to undertake these functions locally to support their future comparative advantage. This is why some countries choose to promote technology development in indigenous firms. Besides the basic ideas, more important is the practical application of government interventions. There are three issues that should be addressed. First, intervention with MNCs needs an appropriate level. If the domestic firms have grown to be able to compete with the MNCs, the intervention is no longer needed and keeping the intervention in place would induce costs. If the intervention expected to be used for a long time, then the domestic firms would have less incentive to promote their production efficiency. All the interventions should be adjusted according to the relative competitiveness difference between domestic firms and MNCs. Second, learning effects should be generated during the government intervention. Without learning effects, the domestic firms are unlikely to improve and grow in R&D. Third, interventions should not be carried out in all the immature industries. The industries that have strong knowledge spillover function to other related industries, such as the automotive industry, should have the priorities of enjoying the government intervention with MNCs. Moreover, the intervention is 20

30 unnecessary for those industries that have rare competition in the global range, even if they are underdeveloped. Theory Utilization in Case Study When it comes to the case study of the Chinese automobile industry, those development processes are quite similar to Dunning s eclectic paradigm, and policies are similar to Lall s theory of FDI utilization. Figure 2. Outward and inward FDI in the Chinese automobile industry ( ). Source: Data from Chinese automobile Industry Yearbook 2014 and calculated by author. According to Figure 2, from 1988 to 1994, China faced a negative NOI position. Because they were net FDI receivers, they mostly took advantage of the country s natural resources. On the other hand, outward FDI was negligible or nonexistent. From 1994 to 2001, the NOI position decreases because of an increase inflow of FDI, while outward investment remains low or negligible. From 2001 to 2004, China exhibited a growing NOI position due to an increased rate of growth of outward FDI and a gradual slowdown 21

31 in inward FDI to 2007 is distinguished by a shift to a positive NOI position as outward FDI stock exceeded inward FDI stock. Finally, from 2008 until today, we find the NOI position of the Chinese automobile industry reflects high levels of inward and outward FDI. Regarding the industrial policies part, even though Lall s theory of FDI utilization is trying to talk about four types of industrial strategy, in the case of China s auto industry, it is also appropriate to associate those four types with four phases in the development of the auto industry. The first phase regarding Lall s theory of FDI in the thesis will be classified as the extremely passive FDI-dependent strategy, and it could be illustrated by Chinese automotive industry policy from 1978 to The second phase incorporating Lall s theory of FDI in the thesis will be the partial strategic FDIdependent strategy, illustrated by the Chinese automotive industry policy from 1994 to The third phase incorporating Lall s theory of FDI in the thesis will be the ISI restructuring strategy, illustrated by the Chinese automotive industry policy from 2001 to And the fourth phase incorporating Lall s theory of FDI in the thesis will be the industrial upgrading strategy, demonstrated by the Chinese automotive industry policy from 2008 until today. Under each phase, industrial environment, industrial characteristics, and industrial policies at each period were analyzed. Upon considering the four types of industrial strategies in the theory of FDI utilization as four phases, we can see it has something in common with Dunning s eclectic paradigm. And in the policy part, it also could be seen as supplementary to Dunning s theory. According to Dunning (1996) and the real situation of the Chinese 22

32 automobile industry, during the first phase, China had insufficient location advantages, 12 thus both inward and outward investment were extremely limited and the MNCs preferred to access these countries through trade as well as enter into nonequity relationships with local firms. Under this situation, we could see the type of industrial policy used by the Chinese central government was relatively passive. It included providing basic infrastructure and a welcoming FDI policy regime. Skill upgrading and domestic technological activity were relatively neglected. During the second phase, China already had locational advantages in primary commodities and natural resources, and according to Dunning (1996), at this time government policies influenced the process through incentives or tariffs, as the competitiveness of local firms at this stage was still very low and the outward FDI remained extremely low. The policy explanation was quite similar to Lall s strategic FDI-dependent industrial policy. Lall pointed out in this phase, there was a strong effort to upgrade MNC activity according to strategic priorities, directing investments into higher-value-added activities and inducing existing affiliates to upgrade their technology and functions. This strategy involved extensive intervention in factor markets (skill creation, institution building, infrastructure development, and supplier support), encouraging R&D and technology institutions, and attracting, targeting, and guiding investments. During the third phase, there was an increase in NOI position. Competition in the domestic market rose as the ownership advantages of the inward investors diffused through the local industry. As a result, the domestic firms started developing their own advantages. The ownership advantages of local firms were 12 Location advantages are related to the host country (factor prices, factor endowments, and distance measured as transport costs). 23

33 increasingly associated with the property of intangible assets and less dependent on government policies; the role of the government was still relevant and oriented towards a reduction of market failures and inefficient industries as well as towards promoting an increasing integration of local and foreign companies, which minimized the delocalization risks. The incentives policy should aim to attract FDI in activities in which local companies do not have competitive advantages as well as to stimulate domestic firms to exploit their own advantages in new markets. And the country s location advantages began changing from cheap labor force and natural resources to created assets (sophisticated markets, qualified labor, technological capacity of the more dynamic sectors, and development of economies of agglomeration). The production processes were more capital-intensive, reflecting a lower cost of capital compared with the cost of labor. It is quite similar to Lall s ISI restructuring policy. At this time, exports were growing from established import-substituting industries where competitive (or nearly competitive) capabilities had developed. The main policy tool was strong export incentives (some, as in Latin America, within regional trade agreements). This led to considerable upgrading, restructuring, and expansion of these industries along with their supplier networks. In some countries, the main agents were domestic enterprises, and in others, they were MNCs. During the fourth phase, according to Lall, China had a kind of autonomous strategic policy, which is quite similar to Dunning s fifth phase in investment development path. As a result, FDI depended less on the condition of the host country and more on the localization strategies of MNCs. Regarding the government, the role of 24

34 government took on a strategic dimension, increasingly behaving as an oligopoly with MNCs and with other governments. 25

35 CHAPTER THREE: FIRST PHASE ( ) Introduction of Extremely Passive FDI-Dependent Automobile Industrial Strategies ( ) Automobile production in China was started in the early 1950s with the help of the Soviet Union. Since then, vehicle production kept rising. Initially, the vehicles were produced mainly for commercial and military use. After 1978, China s economic opening and reforms stimulated a rapid growth in demand for vehicles. According to statistical data from the China Association of Automobile Manufactures (CAAM), China s demand for automobiles (including trucks and buses) stood at fewer than 150,000 in the late 1970s. In the mid-1980s, growth in demand greatly exceeded domestic production capacity, leading to a massive influx of foreign vehicles, especially saloons. In the peak year, 1985, imports amounted to 44 percent of total domestic demand; by the mid-1990s, demand had risen to over 1.5 million vehicles (Table 1). Table 1. Chinese Automobile Production, Production (000) (A) Year Total Trucks Saloons Buses Imports (units) Demand (%) Source: China Association of Automobile Manufactures (1999). 26

36 The rapid growth in demand for vehicles encouraged a proliferation of vehicle makers. In the meantime, a fundamental transformation of the country, from central planning toward economic development of the socialist market economy, also remarkably changed the structure of the automotive market in China. Under the socialist market economy, provincial and municipal governments and ministries had more autonomy to make decisions without the fear of being accused of embracing capitalism. Thus, many of them chose the automotive industry as a pillar industry to develop the economy of their regions. However, the production system that had been built largely for defense purposes was unable to satisfy the new demand. The industry suffered from poor economies of scale, narrow model range, low production capacity, and low technological levels. For instance, the number of automobile assembly plants rose from around 50 in the mid-1970s to over 120 in the early 1990s. But in 1990, only two vehicle manufacturers had an annual output of more than 50,000 units. The majority of manufacturers produced fewer than 10,000 units per annum (MMB, ZQGN, 1996:68). The shortage soon led to a growing number of imported vehicles. Throughout the 1980s, the number of imported cars was higher than the number of domestically produced cars. If illegally imported cars were included, the number would be much higher. This shocked the Chinese central government into more carefully considering its policy towards this hugely important sector. The restructuring in the Chinese auto industry mainly took the form of joint ventures with foreign automobile companies, absorption of foreign direct investment, technology transfers, and making high trade barriers for automotive imports. The Chinese government strongly supported joint ventures, technology licensing, and other 27

37 comprehensive policies at that time. There are two main reasons: (1) Those policies are in accordance with the renewed faith of China in the working of the market economy, as demonstrated by the deregulation and liberalization of markets and the wholesale privatization of state-owned assets. At that time, China was approaching the takeoff stage in its economic development. Competition for the world s scarce resources of capital, technology, and organizational skills was becoming increasingly intense. MNCs are at the forefront of innovation, and their presence provides an effective means of keeping up with technical progress. Their established brand names, global marketing presence, and international flows of information all added to their technological advantages. Therefore, the Chinese government believed that MNCs were among the most powerful means available for transferring modern technologies to China and overcoming obstacles to their utilization. Their presence could only benefit local productivity and competitiveness. (2) Those measures were feasible at that time. The increasing globalization of economic activity and the integration of international production and cross-border markets by MNCs made those policies feasible (UNCTAD 1993). The key ingredients of contemporary economic growth of created assets, such as technology, intellectual capital, learning experience, and organizational competence was not only becoming more mobile across national boundaries but was also becoming increasingly housed in MNC systems. During this period, China expected to use policy tools to support state-owned enterprises (SOEs) in order to get technology transfer and spillover from the developed countries. In other words, all of these FDI policies used by China were the strategies of 28

38 exchange market for technology, which were kinds of passive FDI-dependent strategies. We introduce the main auto policies, both on the supply side and on the demand side. Supply-Side Policy Joint venture regulation The joint venture regulation was a strict central government requirement. Under this regulation, the Chinese central government only allowed international automotive manufactures to make engines and finish cars in joint ventures with local Chinese manufacturers and to possess no more than 50 percent of share holdings. During this period, if foreign companies wished to operate in China, they would be forced to establish their operations as joint ventures with Chinese state-owned enterprises (Oliver and Holweg, 2006). Initially, China asked the Japanese for help. The Japanese exported a large number of trucks and agreed to provide some technical assistance to the Chinese during the early 1970s (Harwit, 1995). But the Japanese were wary of generating potential competitors of their own automobile companies, so the extent and duration of their technology transfer were limited. Then, in the mid-1980s, the international automakers American Motors Corporation (AMC), Volkswagen, Chrysler, Citroen, Peugeot, etc. were allowed to manufacture cars in China in the form of joint ventures with the SOEs as partners. The first automotive joint venture was the Beijing Jeep Corporation (BJC). It was signed between state-owned Beijing Automobile Industry Corporation (BAIC) and AMC in January In this joint venture, AMC was mandated to provide all the new technology for Beijing Jeep. At that time, according to the joint venture regulation, 29

39 AMC duly took a minority stake for automobile joint ventures. For this first joint venture, technology was transferred in the form of complete knockdown (CKD) kits. CKD kits are sets of automotive parts that are packaged in one country and then exported to another for assembly. For the Beijing Jeep joint venture, Jeep Cherokee CKD kits were packaged in the United States by AMC and then exported to China by selling to Beijing Jeep for assembly by the BJC Chinese workers. In 1987, because of marketplace changes and management changes in AMC, BJC was sold to Chrysler. Chrysler s management and perception of technology transfer were totally different from those of AMC. From 1987 to 2005, Chrysler did not transfer any technology to Chinese partners. Thus, in 2005, BJC was sold to Daimler AG. Shortly after the establishment of Beijing Jeep, a second joint venture was established between the Shanghai Automotive Industry Corporation (SAIC) and Volkswagen in October Volkswagen took a 50 percent stake of that venture. Shanghai Volkswagen began automobile production in As car imports fell to some 34,000 in 1990, Shanghai Volkswagen s production of its Santana models reached nearly 19,000 vehicles that year, and Shanghai Volkswagen s output had reached 100,000 vehicles by In the long run, Shanghai Volkswagen has proven to be more successful than Beijing Jeep, as it produced cars that could be used as taxis, government officials vehicles, or cars for the newly emerging business elite. By far, it is the largest annual producer of passenger cars since the mid-1980s. Volkswagen also encouraged its 30

40 foreign parts suppliers to create joint ventures in China, and their resulting products helped Shanghai Volkswagen achieve an 85 percent local content rate by Meanwhile, two new joint ventures were formed: one in 1990 between Volkswagen and First Auto Works to produce Jettas; and another between French Citroen and Second Auto Works (now Dongfeng Motor Corporation) to produce the Fukang compact in During this period, joint venture regulation was a favored government instrument for achieving technology transfer and rapid industrial growth. Under this regulation, technology was transferred to Chinese partners through joint ventures. But we should also note that even though ownership of foreign carmakers was controlled by regulation, carmakers still had complete freedom to decide the kind of technology they transferred to Chinese partners. In the long run, foreign automotive companies would retain most of the control while the Chinese partners would have little real power. Technology licensing Chinese auto companies also licensed technology from foreign firms in these nascent years. Technology licensing involves an agreement whereby an owner of a technology intellectual property (the licensor) allows another party (the licensee) to use, modify, or resell that property in exchange for compensation (consideration). The compensation may take the form of a (1) lump sum royalty, (2) royalty based on volume of production (called running royalty), or (3) right to use the licensee s technology (called cross licensing). 13 Harwit, Eric (2001). The Impact of WTO Membership on the Automobile Industry in China. The China Quarterly: Retrieved

41 In the 1980s, the Chinese government encouraged auto companies to sign technology-licensing agreements with foreign firms in order to push the upgrade of the local auto industry. One prime example is the acquisition of technology for the ubiquitous compact cars used as taxis in many large cities. Tianjin Automotive Industry Corporation (TAIC) licensed technology from Daihatsu in 1986 to produce the Xiali (Charade) mini sedans, which were often used as red taxis in Beijing and Tianjin. In another example, Chang An licensed technology from Suzuki in 1983 to produce its own mini car, which is also used as the yellow taxi in Chongqing (Chang An Automobile Group, 2002). Through licensing of proprietary technology, Chinese auto firms earned substantial income from markets they could not penetrate on their own, and foreign auto firms could have foreign affiliates without high financial and legal risks. The benefits brought by technology licensing in this brief period made profit-oriented Chinese automakers start to passively rely on foreign automakers. Trade barriers Traditional trade barriers, such as a high import tariff, a restrictive annual quota, and an importation license, were adopted in order to protect China s immature automobile industries. The import tariff had been historically high, in the range of 200 to 300 percent in the 1980s and 100 to 200 percent in the early to mid-1990s in the Chinese automotive industry (Huang, 2003), and the Chinese government tightly controlled legal vehicle imports at that time. Japan and Korea commonly used trade barriers to protect their immature automotive industries, and the trade barriers helped them become famous carmaking nations. China wanted to learn from Japan and Korea by adopting trade barriers to protect 32

42 the supported SOEs with a relatively easy environment. However, things were contrary to China s desires and wishes, and trade barriers promoted foreign investment in China and put SOEs into a much more competitive environment. Demand-Side Policy As to the demand-side policy, during the central planning stage ( ), volumes and variety were centrally planned rather than controlled by the market. Most vehicles were trucks, and the production of passenger cars was very limited. Sedans were only available to senior officials, and there were strict regulations on official car use. With the relaxation of planning after 1978, there were many more customers, and the market for sedans and other vehicles increased greatly. For example, there were no taxis during the central planning period, so as restrictions were relaxed, sedans and minivans were produced to supply the taxi market. Also, to help create a market for these new automobile joint ventures, the Chinese government officially permitted private ownership of automobiles starting in The Effects of Passive FDI-Dependent Automobile Industrial Policy ( ) On the one hand, we should note that China was in the first phase of development during this period. At this stage, China normally had insufficient locational advantages due to the limited domestic market (low per capita income), a poorly educated workforce, inappropriate infrastructure, and even political and/or economic instability. As a result, both inward and outward investments were extremely limited, and the MNCs preferred to access these countries through trade as well as to enter into nonequity relationships with local firms (Dunning and Narula, 1996). 33

43 Under these conditions, as Dunning and Narula (1996) suggest, a country owns few created assets and only high-natural-asset countries can attract a significant amount of FDI (natural-resource-seeking FDI). Thus, the government s role in this phase consists mainly of providing basic infrastructure and upgrading the economy s human capital, through educational and training programs, as well as implementing import-substitution and export-promotion policies, which affect the structure of local markets and industries. During this period, Chinese automotive industry policies were extremely simple because the Chinese government at that time just learned to let in MNCs but did not know whether and how much FDI to allow in, that is, if one should exercise selectivity in letting in MNCs (Lall, 2003, p. 35). But China s economic opening and reforms policy helped China achieve the economic growth, including building up basic infrastructures, upgrading the economy s human capital, promoting educational and training programs, and so on. On the other hand, we cannot deny that the Chinese automotive policies proved far from successful at this stage. First, the government ignored the real-world situations in which there was an important distinction between the transfer and utilization of production technologies and the transfer and development of more complex design, development, and innovative capabilities. By then, China had not gained much innovative ability or know-how from foreign firms. The only real requirement for foreign companies was to get the technology into production, and there were no specific stipulations on technology transfer. An authentic example is when Chinese auto companies licensed technology from foreign firms. After obtaining auto models, Chinese auto companies merely produced cars according to the original models even after 17 years, these cars 34

44 remained virtually unchanged from their original model. A passive reliance on MNCs to upgrade and deepen technological capabilities may take a very long time to bear results. Second, The development of high-level capabilities in local firms may be more beneficial than a similar development within MNC affiliates. This would be the case where technological development by local firms leads to greater spillover benefits and linkages (to local suppliers and institutions) within the host economy. (Lall, 2003) The Chinese government tried to make local firms strong, but things went in the wrong direction. All the policies used by the Chinese government during this period, including joint venture regulation and trade barriers, aimed to protect the supported SOEs. The Chinese government only gave the franchise of making cars to several SOEs, which kept the indigenous private firms out of the game. Lack of horizontal competition crushed the creative motivation of SOEs. Moreover, a strong MNC presence in the industry, while stimulating local competitors to be more efficient in their production, would inhibit them from deepening their technological capabilities. Because of the higher risks and the longer learning periods involved in creating a design and development capability, local firms exposed to full MNC competition may have preferred to import foreign technologies proven and ready made from overseas rather than invest in their own R&D capabilities (Lall, 2003). This is the so-called passive FDI-dependent, which means the industrial growth was not driven by FDI but relied largely on market forces to upgrade the structure. To summarize, even though passive FDI-dependent strategies let China benefit from the jobs and tax revenues associated with those joint ventures, it could not help China model itself after Japan and Korea. 35

45 CHAPTER FOUR: SECOND PHASE ( ) Introduction of Partial Strategic FDI-dependent Automobile Industrial Policy ( ) About 1994 and after, the criterion for judging the success of FDI by the Chinese government changed in a way that has made for a more cooperative stance between China and foreign investors. It changed from direct contribution of foreign affiliates to a model with a wider impact: upgrading the competitiveness of a host country s indigenous capability and promoting its dynamic comparative advantage. And the Chinese government started realizing that the learning experience of countries about what MNCs can and cannot do for host countries could enable its government better to understand and assess its consequences and to take action to ensure that it could more efficiently promote its economic and social goals. During this period, the Chinese government started thinking about the problem of having allowed in FDI and whether to intervene selectively in the operations of MNCs. Thus, in March 1994, the Partial Strategic FDI-Dependent Automobile Industrial Strategies Chinese Automotive Industry Policy 1994 was enacted by the central government, as noted in Appendix A. All polices could mainly be divided into two parts: protection and development. The protection policy is quite similar to those in other developing countries. For example, the Chinese government continued to protect all manufacturers located in China (including joint ventures) from international competition by establishing import quotas and stiff tariffs (80 to 100 percent) on both 36

46 vehicles and parts. As to the development policy, it is quite unique. Compared to previous auto policies, the 1994 policy took a stricter development approach. Under this policy, the Chinese government continued to limit foreign ownership in joint ventures to 50 percent, to give the Chinese partners more control and bargaining power. Besides that, according to the new policy, foreign companies were limited to have at most two local partners. Moreover, the Chinese government also created more new restrictions on MNCs, such as local content rule and entry limit. Supply-Side Policy Local content rule The local content rule is commonly used in developing countries to restrict imports as a nontariff barrier and stimulate the development of domestic industries. The Chinese government uses the local content rule in a strict way. For example, to complement the joint venture requirement, the international joint ventures were required to have a local content rate above 40 percent in the first year of production and to increase the rate to 60 percent and 80 percent in the second and third years (KPMG, 2004). This means all joint ventures must localize their parts and components by at least 40 percent (and powerful incentives were created to go beyond compliance). Foreign firms vying for new joint ventures were asked to transfer more knowledge to their partners, and they were told to establish joint technical centers with the aim of training Chinese workers. In local content rules, government policy also prohibited knockdown kits and offered preferential tax rates for enterprises with high localization rates. The policy makers expected that the joint venture format would force in-house technology spillover 37

47 to take place. Affiliated requirements and encouragements include setting up R&D divisions within the joint venture, making products at the international technology levels, intending to export, and giving the indigenous suppliers equal privileges for sourcing contracts. By 1998, officially recorded imports accounted for less than three percent of the Chinese total vehicle market. The leading vehicle makers had all achieved a higher degree of local content, sourcing a large fraction of their components from domestic producers. For example, at Beijing Jeep and Shanghai Volkswagen, the share of local components had risen from under 20 percent in 1987 to over 80 percent by 1995 (Lo, 1997) 14. Every coin has two sides under the local content rule, the policy makers regarded foreign cars produced in China with a high content rate of locally-produced parts as Chinese indigenous cars, and thus some SOEs at that time decided to give up indigenous brands and existing independent car making operations that were regarded as outdated and hopeless, and to focus on supporting and serving the international joint ventures (Luo, 2004). Entry limit In order to form the economy of scale among indigenous auto firms, the central government continued to limit industry entry and still only gave the franchise of making cars to several supported SOEs, particularly the Chinese big three, small three and min two 15. That kind of entry limit also had been implemented on MNCs. International 14 Lo Dic. Market and Institutional Regulation in Chinese Industrialization, (London: Macmillan, 1997). 15 The big three were First Automotive Works, Shanghai Automotive Industrial Corporation, and Dongfeng Motor Company; the small three were Beijing Automotive Industrial Corporation, Tianjin 38

48 automakers were allowed to manufacture cars only with those authorized SOEs in their joint ventures. Actually, only Volkswagen, PSA, Chrysler, and Daihatsu gained the right to produce cars because the policy makers decided China did not need too many passenger cars. Making cars with Volkswagen, Citroen, and Peugeot were already enough. They were worried that too many companies entering the industry would bring overcapacity like in the U.S. automotive industry. Meanwhile, indigenous private investment was forbidden in automobile production, although allowed in other businesses like textile, television, etc., because the government regarded the automotive industry as a pillar industry that needs government central planning the most. To summarize, entry limit policy on foreign automakers limited the number of MNCs but did not achieve the goal of selectivity on FDI. Limiting the industry entry policy was aimed to reshuffle the top 20 auto manufacturers into just three or four SOE enterprise groups in order to meet foreign competition; however, the entry limit deprived some private Chinese automakers of their competing rights. In order to push MNCs to transfer more complex design and innovative activities to their Chinese partners, the Chinese government made some new policies to improve and strengthen SOEs production ability. Those policies included consolidation and comprehensive encouragement on the supply side and market creation on the demand side. Automotive Industrial Corporation, and Guangzhou Automotive Industrial Corporation; and the mini two were Changan and Guizhou Aviation (Xia, 2002). 39

49 Consolidation In the mid-1990s, the Chinese automotive industry was highly fragmented in terms of the quantity of manufactures, geographical distribution, and the ownership of manufacturers. This fragmentation led to inefficiency of the scale-sensitive automotive production. The Chinese automotive industry was highly fragmented in terms of the number of manufactures, its geographical distribution, and the ownership of manufacturers at that time. This fragmentation led to inefficiency in scale-sensitive automotive production. The fragmentation or diseconomy of scale took three patterns of manifestation: fragmentation by manufacturer, fragmentation by ownership, and fragmentation by region. Fragmentation of manufacturers In the 1980s, the Chinese government implemented industrial protectionism polices and regulations to protect its immature automotive industry. With the high price margin, many municipal governments started to produce cars within their affiliated enterprises. At the same time, a lot of military plants also tried to convert their manufacturing operations into automotive production. However, all those regulations made inefficient automotive enterprises highly survivable and profitable. The government s pursuit of a scale economy filled the Chinese automotive industry with various automotive firms with low production rates that were controlled by different regional governments and in different provinces. The profitable automotive business attracted a large number of state-owned entrants in the 1980s, and most of them still inefficiently remain in business, with the profits made due to market protection. This is the reason for the large number of manufacturers. 40

50 Fragmentation of ownership Other reasons for the fragmentation are raveled together mainly by the governmental mechanism that affected the ownership structure in China. And the diversified ownership is the major reason associated with the large number of manufacturers and the fragmentation by region. The ownerships of major indigenous automotive industry corporations in China are listed below in Table 2; in fact, the political ownership to some extent determined the geographical distribution of automotive corporations in China. All these facilities were spread over the country s territory and belong to different governmental bureaus or administrations. Table 2. Ownership of Chinese Indigenous Automotive Industry Corporations in 2000 Indigenous automotive corporations First Automotive Works Dongfeng Motor Corporation ChangAn Automotive Corporation Shanghai Automotive Industry Corp. Beijing Automotive Industry Corp. Guangzhou Automotive Industry Group Hafei Motor Co. Ltd Chery Automobile Co. Ltd Source: Company websites and various sources. Fragmentation of region Ownership Central government Central government China Weapon and Arming Group (central government) Shanghai municipal government Beijing municipal government Guangzhou municipal government China Second Group of Aeronautic Industry (central government) Wuhu municipal government Because nonautomotive manufacturing enterprises were owned by different central government agencies and different regional governments and were therefore originally dispersed the automotive industry was inevitably scattered geographically 41

51 when these plants were turned into automotive operations. This is the reason for the fragmentation by region. In 1998, The State Planning Committee (SPC), the nation s economic regulator, was renamed the National Development Commission (NDC). On behalf of the central government, the NDC was dedicated to regulating the big automotive groups in order to achieve industrial efficiency. Based on industry experience and technological capacity as well as general regional balance considerations the NDC determined to support eight Chinese car assemblers, which were later known as the big three, small three, and two mini. Big three refers to three major car assemblers, FAW, SAW, and Shanghai- VW; small three refers to three small assemblers, Beijing-Cherokee, Tianjin-Charade, and Guangzhou-Peugeot (later Guangzhou-Honda); and two mini refers to two new firms with defense-industry background their parent companies were the China Ordnance Industry Corporation and the Guizhou Aviation Industry Corporation, and through their strong bargaining power and close relationships with top government leaders, they obtained special permission from the NDC to produce mini cars. China intended to focus most of its own energy and investment on those eight companies. According to that policy, we should note that only a small number of firms, which we call SOEs (controlled by the central government), could enjoy the support from the central government. Other local firms did not have right to reap the benefits brought by the consolidation policy. The Chinese government also tried to convert the myriad small vehicle plants to component suppliers for the giants of the industry (CDBW, 7 September 1997). Lossmaking firms in the sector were to be declared bankrupt and sold their assets to large 42

52 firms or merged with them. The Ministry of Machine Building announced that each year it would withdraw the licenses from many small loss-making plants if they continued to make losses or were reluctant to merge with other plants. Promising enterprises were to receive priority for government endorsement in overseas listings and issuing industrial bonds abroad (China Economic Digest, Spring 1997:20). The consolidation process was very slow. Based on the current ownership structure involved with fragmented but strong political power of various ambitious local governments and central government ministries, large-scale regrouping (merger and acquisition) was still difficult to achieve across different political administrations. At that time, very few mergers or acquisitions were observed, with only FAW acquiring Tianjin Automotive Industry Corporation, SAIC acquiring Liuzhou Wulin Motors with GM, and Changan controlling Jiangling Motors with Ford. If the political regulation system remained unchanged, it would take a long time for China to consolidate its automotive industry to the level of the U.S. counterpart (although deepening consolidation was predictable along with the general industrial maturation process). Although the NDC tried to foster the formation of industrial efficiency in indigenous auto firms, the result was far from satisfactory. At that time, the rapid growth of output from the government s targeted key point plants produced an explosive process of concentration of market share in saloon vehicle production. Among saloon market share, Shanghai Volkswagen s joint venture with Volkswagen accounted for 47 percent of total domestic saloon vehicle production, and the Tianjin Charade joint venture accounted for 20 percent by 1996 (Table 3). We can see that joint ventures accounted for almost the entire output of saloons while the Chinese partners lacked the capability to 43

53 develop new vehicles independently. As to the technical disadvantages, a key problem lay in the shortage of funds. In the automobile industry, it costs at least US$150 million and takes several years to develop a new product. None of the Chinese auto enterprises found this affordable (Beijing Review, 4 October 1999). The government wanted to offer some help, but it already earmarked a large fraction of its funds to support the auto industry in the emerging giants. It was bluntly recognized that China had failed comprehensively to catch up with the global giants of the industry (Peter Nolan, 2001:540). Table 3. Saloon Vehicle Production in China, 1998 Producer name Production (000) % Shanghai Auto/Volkswagen JW Tianjin/Daihatsu JV Yiqi/Volkswagen JW Dongfeng/Citroen JV Beijing Jeep/Daimler-Chrysler JV Others Total Source: ZQJYZ, ZQGN (1999:5-7). Note: Total number of producers = 19. Comprehensive encouragement policy Encouragement policies were mainly used in three areas: (1) Enterprise Organization Policy, the formation of automotive industry groups to attain critical-mass state support for enterprises that exceeded certain production volumes and R&D effort; (2) Technology Policy, the encouragement of independent product development; and (3) Investment Policy, the encouragement of automotive enterprises to raise development funds from various sources and transregional and transdepartmental investment to support increased industry concentration. 44

54 Demand-Side Policy Market Creation To stimulate the market, the Chinese government reaffirmed its encouragement of private ownership of passenger cars. As noted, the Chinese government officially permitted the private ownership of vehicles in According to the consumption and pricing policy in Chinese Automotive Industry Policy 1994, the policy encouraged individual ownership of automobiles, and prices of civilian vehicles (except sedans) were to be decided by enterprises according to market demand. However, many local governments used the consumption and pricing policy to make money. In other words, the slow progress in the development of mass auto assembly was largely due to local protectionism. Local governments used regulations and policies to favor the purchase of vehicles produced within their jurisdictions, which created protected local markets resulting in a pattern of spatially dispersed small and inefficient indigenous assemblers. Local protectionism also operated in the favor of large assemblers, including joint ventures. For example, the Shanghai municipal government once required every city taxi to be Shanghai-Volkswagen s Santana model. It still levied a lower license tax to Santana buyers who lived in its suburban areas. The central government also used protective measures to protect favored firms. In 1996 and 1997, Shanghai-Volkswagen initiated a price war by dropping the selling price of its Santana by 20 percent. This effort consolidated the car market, but that came to an end just a year later when the central government stepped in and set a floor for price reductions. 45

55 The Impacts of Partial Strategic FDI-Dependent Automobile Industrial Policy ( ) Promoting industrial development by using FDI was necessary to give birth to the 1994 automobile policies. In order to more clearly show the results of the new automobile policy, this analysis is divided into two parts: vehicles and components. Vehicles Since China had plenty of resources, cheap labor, and big markets which met with MNCs expectations the stricter requirements in 1994 automotive policy did not seem to deter the next foreign investors in China. After the 1994 policy was issued, almost every big multinational automobile firm bid on a project to establish a joint venture with Shanghai Auto Industry Corporation, considered by many to be the best Chinese passenger-car firm. In the end, General Motors made the largest single foreign investment ever in China as of 1997 when it established its joint venture. Also in 1997, Honda took over Peugeot s joint venture with Guangzhou Automotive Manufacturing Company, and then Ford entered into negotiations with Chang an in There was a veritable flood of investment into the Chinese auto industry during the 1990s from both the Chinese government and foreign sources. The restructuring also resulted in a rapid increase the proportion of passenger cars in total vehicle production. The share of the car rose from 2.4 percent in 1980 to 31.2 percent in 1998, with light vehicles (trucks and buses) increasing from 19.5 percent to 29.3 percent, while mid-size trucks fell from 53 percent to 11.3 percent. Accordingly, major car and light vehicle assembly centers, like Shanghai, Tianjin, and Nanjing, had become new centers for vehicle production and important locations in the geography of China s auto industry. 46

56 Looking at the data, the new policy seems to have been hugely successful. But upon further exploration, we find that the rapid increase in light vehicle production, like saloons, was merely created by foreign firms or JVs (Table 3). The large decrease in midsize trucks share stems from the extent of foreign involvement in the medium-duty truck sector being much lower than in the saloon car sector (Table 4). Table 4. Main Medium-Duty Truck Producers in China, 1998 (000) Producer Output Yiqi Group Company 72.2 Dongfeng (Erqi) Auto Company 45.7 Dongfeng Liuzhou Auto Company 5.5 Hubei Special Vehicle Company 1.7 Dongfeng Lianying Company 1.5 Dongfeng Hangzhou Auto Company 1.4 Luoyang Auto Company 0.6 Dongfeng Nanjing Auto Company 0.5 Source: ZQJYZ, ZQGN (1999:340). Note: Share of output produced by the top producer = 55.6%; total number of producers = 13. Components From fragmentation to consolidation Because the consolidation of the auto parts industry lagged behind vehicle assembly, lots of automakers used cheap and low-quality components manufactured by local firms. These local firms were typically township and village enterprises with small entry costs. According to official records, by the mid-1990s, it is estimated that there were around 4,800 components manufacturers across the country, most of which were tiny (FT, 5 March 1996). But in 1995, according to Chinese official statistics, there were 1,600 component makers (Table 5). Then in 1996, the Ministry of Machine Building released a list of 300 companies in the components sector that would be supported. They 47

57 were eligible for policy loans and other preferential policies (FT, 5 March 1996). In the late 1980s, there were at least 200 enterprises manufacturing internal combustion engines, but in the 1990s, even in the medium-duty truck diesel engine sector, there were around 10 main producers (Bear, Stearns, 1994:14) and several smaller manufacturers. Table 5. Size Distributions of Chinese Component Makers, 1995 Plant size Number of plants Value of sales (million yuan) Sales per plant (million yuan) Total Large Large middle Small middle Small Source: MMB, ZQGN (1996:66). Boom under local content rules China s tough local content rules were a boon to the components sector as Chinese vehicle production rose (FT, 21 May 1996). These forced the expanding automobile industry to purchase an increasing share of its inputs from local component makers and push them to improve quality, provide timeliness of delivery, and reduce costs of production. Even in the absence of foreign investment or government policy towards consolidation of the sector, it is likely that the growth of automobile output and the increasing role for market forces would have produced a rapid change in the institutional structure of China s components industry (Nolan, 2001:543). Foreign investment was encouraged in the components sector. By 1995, there were over 60 joint ventures in the automobile sector, mostly for the manufacture of components (MMB, ZQGN, 1996:352). In the mid-1990s, the pace of foreign investment in components accelerated sharply, with many of the global leaders and specialist 48

58 components industry investment companies entering the industry. Also, joint ventures with globally powerful firms in the components sector were a major element in the rapid institutional change of the engine-making sector (Table 6). Table 6. FDI in Chinese Automobile Component Sector ( ) Company Number of JVs built in China Ownership in China JVs Major products in China Type1: Components industry investment company ITT Automotive Pacific 2 - Auto electrical systems, auto-locking brake systems, fuel handling systems, sensors, switches, and aftersales products Asimco 13 - Auto components except engine Type 2: Investments by specialized multinational components company Delphi 7 - Produced 600,000 automotive generators per year Robert Bosch 4 50% Computer-controlled EMS (engine management systems), diesel engine fuel injection components Valeo 6 Over 49 percent of the equity Denso 5 In the two JVs established in , it held a minority share, but in the three established in , it held a majority stake Type 3: Foreign investment in engine making Company JV partner Ownership in China JVs Project Volkswagen Mercedes-Benz First automobile works South China Motor Corporation Clutch, air-conditioning, automobile electrical systems, and electric motors Air-conditioners, alternators and starters, magnetos, CDI amplifiers and ignition coils, electronic control components 40% Produced around 500,000 passenger car engines 45% Built 100,000 engines for minibuses (as well as 60,000 minibuses) annually 49

59 Toyota Tianjin Auto 50% Produced 150, liter car engines, mainly intended for use in the Charade mini-passenger vehicle produced by Tianjin Auto under license from Daihatsu Hino (a truckmaking affiliate of Toyota) Mitsubishi Lucas-Varity China National Heavy Duty Truck Corporation China Aerospace Automotive Industry Group Tianjin Engine Works - Produced truck engines - Manufactured vehicle engines of 2.0 and 2.4 liters, produced 150,000 units per year 50% Manufactured diesel engines for use in trucks, buses, and powergenerating equipment, produced around 50,000 engines per year Cummins Dongfeng 50% Manufactured truck diesel engines Source: Summarized and complied from various sources. However, looking behind the boom in the Chinese component market, Chinese component makers should learn lessons from Brazil. The Brazilian components industry offered an important lesson to China. The Brazilian automobile industry was much further advanced than the Chinese automobile industry, with a total output of vehicles and components roughly three times that of the Chinese in the mid-1990s (Mukherjee and Sastry, 1996). Like China, it developed a proliferation of mainly small indigenous component makers totaling around 1,000 in For decades, indigenous firms had been able to charge high prices for often low-quality products (FT, 9 July 1997). The rapid institutional change in the global components industry and fast expansion of international investment by the global giants of the auto industry had accelerated foreign penetration of the Brazilian components industry (FT, 9 July 1997). Small indigenous makers found it hard to compete with JVs established by the multinational giants. The 50

60 only way to attain the technology and economies of scale needed to survive was to join forces with the big international groups. Thus, many manufacturers could only hope to survive in the second tier, supplying the motor industry s suppliers (FT, 9 July 1997). Chinese companies always wished to rely on others to help and teach them, which was a big mistake. During the second phase, as a country develops, the improvement of its locational advantages leads to a growth of inward FDI, especially in primary commodities and natural resources as well as in industries that are intensive in physical capital and lowqualified work sectors whose endowment of created assets are scarce. At this time, government policies may influence the process through incentives or tariffs, as the competitiveness of the local firms at this stage is still very low and the outward FDI remains extremely low but larger than in the first stage (Dunning and Narula, 1996). After analyzing the vehicle and component part, it is partially true that intervention could be used to promote the upgrading of MNC activities from those that are simple, labor-intensive, and low technology to those that are more complex and demanding by guiding foreign entry or providing strong incentives to all investors. As Dunning (1981) states, this opening up of the home market to foreign investors allows the construction of more and better infrastructures which are technologically beneficial for training and qualification of local work and the emergence of a national industry more intensive in resources. There is also an increased integration of domestic firms in MNC s production chain, as well as a learning-by-doing and know-how transmission process to local firms. This allows these firms to create or upgrade their ownership advantages, which induces the emergence of outward FDI directed to adjacent countries in order to 51

61 find new markets (market-seeking FDI), and, to a lesser extent, strategic asset-seeking FDI in high-income countries. During this period, government policies may influence this trend, through incentives or tariffs, because the competitiveness of the local firms at this stage is still very low and the outward FDI remains extremely low but larger than in the previous stage. However, in this case study, even with strict government policies, China still failed to completely establish independent technological capabilities of the indigenous SOEs and lost control of the Chinese passenger car market to international automakers. The main reason is intended routines of the 1994 policy were distorted. At the very beginning, the joint venture regulation, trade barriers, entry limit, as well as the local content rule were created in order to cultivate advanced international competitiveness of SOEs. But in the end, the four development policies worked together and created the oligopoly. The entry limit regulated many private investors out of the automotive production business. Also, many automotive groups that created international joint ventures gradually gave up their own brands and merged their independent plants into the joint ventures to supply parts in order to solely pursue the local content rate of joint ventures. Thus, the pursuit of local content rate also indirectly contributed to the oligopoly of the international joint ventures. Given the market power of the oligopoly, both the local partners and their international joint venture partners made huge profits relying on the high price for cars sold in China. Oligopoly naturally hinders technology innovations. The foreign partners postponed the update of the product line and kept selling outdated models even in a fast growing market. The oligopoly market environment and the crossholding joint venture structure reduced the international automakers incentive to conduct 52

62 R&D activities in the joint venture located in China. Moreover, because local firms also could become foreign firms potential competitors in the future, international firms would never really help local Chinese firms understand their key product technologies. Meanwhile, when foreign partners did not transfer the product technological know-how actively, the indigenous SOEs also dramatically lost the motivation to conduct their independent product R&D and production activities. Because local private investors were regulated out of this game, with their franchise obtained from the government, the only important way to guarantee good profits for a Chinese SOE was to pick up a good foreign partner. By sharing the profits of the joint ventures, the SOEs earned a lot of money without making any significant cooperative or independent efforts. In this situation, the SOEs refused to risk investing in R&D and developing independent products. Step by step, the SOEs became weaker and weaker in technological capabilities and brand creation. 53

63 CHAPTER FIVE: THIRD PHASE ( ) Regulation Liberation and Impacts ( ) After China entered the World Trade Organization (WTO) in 2001, the Chinese government started to reform its automotive industry policies and loosen the industrial regulations in accordance with its WTO obligations. Consequently, some transformative changes occurred. As illustrated in Table 7, the tariff rate for imported entire cars was lowered to 30% on January 1st, 2005, and scheduled to drop to 25% by July 1st, The tariff for automotive components and parts decreased to 30% first and was scheduled to lower to 10% after July The historical automotive import quota increased by 20% per year and was scheduled to phase out by Even though joint venture style cooperation was still mandatory for MNCs in the automotive industry, the local content rate was no longer required after More foreign and indigenous private investors were allowed to operate automotive businesses in China, especially in the passenger car market. 54

64 Table 7. Tariffs, Pre- and Post-WTO Membership Before WTO entry After WTO entry Tariffs 200% in 1980s, % in 1990s 25% for CBU importation and 10% for parts and components importation after July Import quotas Local content requirements Auto financing for Chinese domestic customers Foreign participation in sales and distribution 30,000 vehicles per year allowed from foreign carmakers 40% in first year of production, increasing to 60% and 80% in second and third years, respectively Foreign, nonbank financial institutions prohibited from providing financing Limited to wholesaling through JVs; prohibited from consolidating sales organizations of imports, JVs Quota increased by 20% per year, phased out by 2006 No local content ratio requirement after 2002 Foreign, nonbank financing permitted in selected cities before gradual national rollout after 2002 By 2011 be allowed to own vehicle wholesale, retail organizations, integrated sales organizations Source: Gao (2002) and materials from Chinese Automotive Yearbook 2008 and translated by author. Because of the policy changes and the huge potential market in China, nearly all the major international carmakers entered the Chinese automotive market. More diversified car models were been introduced, in comparison with the oligopoly era before 2000, when there were only a few models available. And a complex partnership structure between local and international firms was established gradually in this period, as shown in Figure 3, below. All these transformations increased the competition in the domestic market and drove firms (including international joint ventures, the state-owned firms, and local private firms) to promote their product quality and design, decrease costs, and lower prices. 55

65 Figure 3. Partnership structure between local and international auto firms in China. Source: Luo (2006) and 2004 Yearbook of China s Automotive Industry. The Impact of the Reduction of Tariffs Price differences have had an impact on the Chinese car industry. After tariffs on cars were reduced, foreign cars gained price advantages and the prices of domestic cars categorized in the same grade were significantly higher than the prices of foreign cars in 56

66 the same category. Overall, the higher the category and price of car, the larger the gap in price between foreign and domestic. Comparing prices is also very complicated. The domestic car market had been regulated by the Chinese government over such a long term that it was insufficient where competition is concerned. Under these circumstances, domestic car profits were much higher than foreign car profits. Because of this, comparing the sales prices of the cars did not accurately reflect the changes that the tariffs had created. It is found that price determines the competitiveness of a car model. If the average price differences between domestic and foreign cars are less than the tariff on foreign cars, the competitiveness of domestic cars is weakened, and vice versa. For example, after 2006, the tariff on cars was reduced to 25%; if the average difference between domestic and foreign cars in the same grade is less than 25%, the domestic cars will not be influenced in the price competition. It means the domestic cars competitiveness depends on not only tariff but also the total cost of a car. Also, the impacts on domestic high-grade and low-grade cars were different. When the average tariff was reduced to 25% in 2006, it was possible that high-grade cars were at a disadvantage while low-grade cars were still competitive. The tendency may have been that the competitiveness of domestic low-grade cars would improve through intensive competition while the reduction of cost and price of high-grade cars would not be compatible with the reduction of tariff. Consequently, foreign cars dominate the high-grade car market and domestic cars dominated low-grade car market. 57

67 The Impact of the Change of Car Import Quota After 2001, the quota of import cars and car parts increased yearly by 20%, based on a figure of $6 billion. In 2006, the quota was cancelled, meaning that the import quota of 300,000 cars per year would no longer be in effect. However, car production volume is just 605,000 in The import quota is about 50% of annual car production volume (Guo, 2003). Because of this, the import quota on cars in China produced a strong challenge for the domestic automobile companies. Because the average tariff on cars was still high before 2006, the prices of foreign cars were still higher in the Chinese domestic car market. Even though foreign cars were expensive, as a whole, foreign cars were superior to domestic cars in terms of performance and integral quality. However, domestic cars may have been at a disadvantage in the quality competition. Despite greater quality, foreign cars could not have a great impact on domestic cars even if the import quota were cancelled. Under that circumstance, because of the price advantage of domestic cars caused by the high tariff, the impact of quality advantage of foreign cars was limited. But things changed when the average tariff on foreign cars was reduced to 25%, and foreign cars had an impact on domestic ones in terms of both price and quality; domestic cars without protection from import quota were heavily pressured. Especially in the high-grade car market, the market share of foreign cars boosted. The influence of cancellation of quota appeared. The Impact of Opening the Chinese Car Industry to Foreign Investment Besides the positive changes on the supply side (manufacturer), the demand side (consumer) also served as a key driver for Chinese automotive market growth at that time. The increase in income in the metropolitan areas and the rise of an affluent middle 58

68 class made private purchasing become the mainstream of auto consumption. The upgraded products attracted the enthusiasm of potential car consumers and drove the auto market growth. From 2001 to 2004, the average annual growth rate of motor vehicle production in China was as high as 23.5 percent much higher than that in the 1990s (12.6 percent). In 2004 alone, the output of motor vehicles in the country totaled 8.9 million units, more than four times that in The growth of passenger car production was even more astonishing after China entered the WTO in Total output had increased by nearly one million units in each year since 2002 an annual growth rate of 34.3 percent. At the same time, side effects also emerged. Due to the fast market growth and rich profit in China, almost all the global carmakers as well as the domestic auto groups expanded their capacities in China. Hence, a rather low capacity utilization rate was induced in the Chinese automotive industry. Capacity utilization is a vital performance measure of the capital-intensive automotive industry and very sensitive for determining companies financial turnouts (Holweg and Pil, 2004). As shown in Table 8, the capacity utilization in the auto industry is only 50% to 60%, far below the average utilization in the western automotive industry of around 80% (Holweg, Luo and Oliver, 2005). The capacity utilization of the indigenous firms is incredibly low, at 20%. Table 8. Capacity Utilization Rate of the Chinese Automotive Industry Type of automaker Capacity utilization rate International joint venture plants 70.1% Independent plants of top five SOEs 50.4% Indigenous local private firms 20.2% Industry average 51.3% Source: Matthias, Luo and Oliver (2005). 59

69 Even in this situation, most manufacturers were still expanding their facilities in China. Global automakers, including Volkswagen and GM, continued adding investment and tried to double their annual production capacity in China. Local private carmaker Geely also planned to increase its capacity from 210,000 to 650,000 by 2007 (KPMG, 2004). Perhaps it believed that sustainable growth in the future could help the company deal with this problem. During this period, new policies were not made. Thus, the automotive market growth was driven merely by regulation liberation and country s overall economic growth. The trend in domestic automakers was to promote technology spillover and learning by doing. On the other hand, we should also note that severe overcapacity started to bring negative effects to the Chinese automotive market. New Automotive Policy and Effects ( ) New Automotive Policy In order to bring policy in line with China s World Trade Organization (WTO) membership obligations, China set out a roadmap for the industry s development in Chinese Automotive Industry Policies It was released by China s State Development and Reform Commission (Appendix B is the summary of Chinese Automotive Industry Policies 2004 ). Consisting mainly of 12 chapters, the new policy superseded the previous policy that had been in place for about 10 years and which had become increasingly outmoded. The new auto policy was directed at achieving a degree of rationalization among the domestic manufacturers and cultivating a number of efficient export-led auto companies. 60

70 Encouragement policy The 2004 China automotive industry policy offered encouragement and strategic direction, rather than just strict regulation. The new policy encouraged local private firms to join global competition and it was expected that global components would be produced in China not only for the domestic market, but also for exporting to North America, Europe, and Japan (Holweg, 2006). This indicates a significant change in the role of the government in economic matters, as it was now committed to using market forces to influence the industry s future rather than government-prescriptive policies. Moreover, under the new policy, R&D expenses were tax deductible in order to encourage local R&D activities and the development of indigenous intellectual property. And there were also several measures that provided incentives for local component production and sourcing. On the demand side, policy supported private car purchases by encouraging the development of various auto-related sectors such as financing and insurance. A fair and open market for both manufacturers and consumers would be strengthened by the application of standard nationwide administrative and registration fees in lieu of various local government levies. In developing the secondhand car market, related government units were required to cooperate on matters such as standardizing transaction charges. FDI and importation policy In the meantime, the new policy still retained some restrictions on foreign investment and some limitations on vehicle and parts imports. Under the new policy, foreign investment in vehicle assembly projects continued to be capped at a maximum of 50 percent. For vehicle assembly projects geared to export and located in an export- 61

71 processing zone, foreign investment of more than 50 percent was permitted, subject to the State Council s endorsement. This cap was not required to be reduced under China s WTO commitments and was an effective way for China to retain a significant stake in the sector and to assist the larger domestic manufacturers. To curb overinvestment in the sector, existing dormant vehicle production companies could not transfer their manufacturing licenses to nonautomotive enterprises. At the same time, a higher entry barrier with a minimum investment size of RMB 2 billion (US$241 million) was stipulated for nonauto companies to enter the industry in the new policy. The Chinese government also started to implement selected economic cooling-down policies, including discouraging bank lending and slowing approval for investments. In addition to these macroadjustments, consequent lower lending from the banks and frequent price cuts reduced demand many price-sensitive Chinese consumers delayed buying cars as prices continued to fall. All of these policies (both foreign and local) would help China to reduce overinvestment that could result in overcapacity in the automotive sector. Regarding the import limitation, beginning in 2005, imported vehicles could no longer be stored in bonded warehouses in China. That means import duties would be collected at the time vehicles landed in China, and imported parts would be charged the same level of import tariffs as complete vehicles. The policy demonstrates the government s desire to monitor and shape growth in this sector. Moreover, in 2005, in order to stem the tide of CKD imports by MNCs, the Chinese government announced a new regulation on the import of automotive parts and components. If 60 percent or more of the parts and components used in a vehicle assembled in China were imported, then 62

72 CKD imports were treated as CBUs (i.e., a 25 percent tariff would be applied). Furthermore, imports of the following items were also being treated as CBUs: engine/chassis assemblies; assemblies consisting of transmission, steering, braking, frontaxle, and rear-axle components; and assemblies consisting either of the engine or chassis in combination with three of the aforementioned five components (GACC, 2005). The Effects of New Automotive Policy During this phase, according to Dunning and Narula (1996), there should be an increased rate of growth of outward FDI and a gradual slowdown in inward FDI. The ownership advantages of local private firms are increasingly associated with the property of intangible assets and less dependent on government policies. But the role of the government is still relevant and oriented towards a reduction of market failures and inefficient industries as well as towards promoting an increasing integration of local and foreign companies, which minimize the delocalization risks. The main objectives of the incentives are to attract FDI in activities in which local companies do not have competitive advantages, as well as to stimulate domestic firms to exploit their own advantages in new markets. Due to the encouragement policy and the intense competition in the automotive industry, international carmakers started to consider conducting more local design and development jobs in China. For example, the new 2006 Buick LaCrosse Chinese version was a model completely designed by PATAC in Shanghai, the joint venture R&D center of GM and SAIC. The deeper technological spillover effect began to take place on indigenous carmakers, including SOEs and joint ventures. 63

73 By accumulating earnings during the golden years of the market boom from 2001 to 2004 and the under the support of new governmental encouragement policies, local carmakers began to develop or acquire car designs individually or by cooperating with international designers. For example, domestic automakers Geely and Chery were dedicated to joint product development with international technology companies like AVL, Pininfarina, Ricardo, and Bertone (Luo, 2005a). Finally, Chery jointly developed 18 up-to-date engine models from 0.8L to 4.2L with AVL, and all these engines met the Euro IV emission standard. Chery fully owned the intellectual property of these engines. But the ambitious policy is also a poison to indigenous carmakers; in order to rapidly capture market share, indigenous carmakers started to use other companies technological skills without any authorization. Afterwards, intellectual property disputes arose, and many indigenous automakers were accused of copyright infringement. New restrictions in the new automotive policy also helped China reduce overcapacity, reduce overinvestment, and protect the rationalization of the local auto market. Consequently, until 2007 China was the third-largest country in motor vehicle production, trailing only Japan and the United States. The number of passenger cars on the road in China had increased from about 6 million in 2000 to over 29 million in 2007 (China Automotive Industry Yearbook 2008). But it led to a trade dispute between China and the European Union, the United States, and Canada. The latter three jointly lodged a complaint against China with the WTO in September 2006 and demanded an investigation into China s new regulation on imports of parts and components. On the other side, the Chinese government made a concession, postponing the implementation of the new regulation by two years. 64

74 During this period, since joining the WTO and developing domestic carmakers technological capability, the Chinese carmakers started to export cars to some undeveloped or developing countries. We can see China had already made some progress in the automotive industry from 2005 to But that progress could not meet the extremely ambitious objectives of the new policy made by the central government. The Chinese government aimed to encourage self-reliant product development and local brand development, building up a few famous brands at world-level (top 500) automotive groups before The Chinese government also hoped China would become one of the major global automotive production countries, and exporting in large volumes. During this period, since joining the WTO and developing domestic carmakers technological capabilities, the Chinese carmakers started to export cars to some undeveloped or developing countries, and vehicle production in China rose rapidly. Thus China had already made some progress in the automotive industry from 2005 to At this stage, we could see the policies were quite similar to Lall s ISI restructuring strategies. According to Lall, the main policy tool was trade liberalization or strong export incentives, and this led to considerable upgrading of these industries the main agents in China were domestic enterprises, and in other countries, they were MNCs (Lall, 2003). On the other hand, we should note that production was still mainly to serve the expansion of the domestic market, and exports were still limited. In 2007, around 6 million vehicles were produced, but the vehicle export volume was only 614,412, as noted in Table 9. The main export destinations were Southeast Asia, Latin America, Africa, the Middle East, and some other developing countries, as noted in 65

75 Figure Among the international automakers, Honda was the only one that largely exported vehicles manufactured in China to overseas markets. In 2005, 11,047 Jazz, which were produced in the joint venture owned by Honda, GAIG, and Dongfeng, were exported to Europe. We should also note that in this joint venture, Honda had 65 percent ownership. The foreign ownership cap of 50% did not apply to the exportation-oriented joint venture (Luo, 2005). Besides international carmakers, domestic carmakers Geely and Chery also exported overseas in low volume. Geely exported 29,067 cars in 2007 to some less developed countries. Chery sold only about 18,000 cars in overseas markets until 2007 (China Automotive Yearbook 2008). Low automobile export volume was mostly due to the limited quality and brand power of the Chinese products. Besides direct exports, the domestic automakers set up CKD plants jointly with other developing countries, including Egypt, Viet Nam, Iran, Russia, and Turkey. Assembling automobiles in developing countries could help China skip the import tariff and benefit from cheaper land and labor. But compared to the domestic market, the sales volume and profits were extremely low in those developing and undeveloped markets, and it partially quenched the exportation passion of domestic automakers. 16 According to data from CATARC, in 2005, 710,540 special vehicles (e.g., forklifts, golf vehicles, and all-terrain vehicles) with an engine volume <=1000ml were exported in

76 Table 9. Chinese Automotive Export Data in 2007 Company Export volume Export destination FAW 28,823 The Middle East, Southeast Asia, Russia SAIC 60 Chile Dongfeng 9,172 The Middle East, Southeast Asia ChangAn 2,001 Algeria, Thailand, Vietnam, Russia, Zambia, Peru, Morocco, Sri Lanka GAIG 43,124 Hong Kong, Europe BAIC 14,134 South Africa, Russia, Cuba NAC 9,135 Russia, Algeria, Vietnam SouthEast 9,478 The Middle East, Southeast Asia, Eastern Europe Chery 119,891 Russia, Iran, Egypt Geely 29,067 Russia, Ukraine, Venezuela, Syria GreatWall 28,519 Cuba, Europe Zhongxing 10,000 The Middle East, Africa, Russia BYD 6,690 Russia, Algeria, Ecuador, Nigeria, Columbia, Egypt, Chile Hafei 14,569 The Middle East Source: Materials from Chinese Automotive Yearbook 2008 and translated by author. 12% 10% 42% The Middle East La4n America 13% Eastern Europe Asia 24% Other Figure 4. World distributions of Chinese automotive exports in Source: Organized and translated by author, materials from various Chinese auto magazines. In summary, new policy brought both positive and negative effects to China. On the one hand, China gained a deeper technological spillover effect from international auto companies. And the regulations of the new auto policy to some extent encouraged 67